Economists, analysts and pundits have been talking about the U.S. Federal Reserve tapering its long-standing bond purchase program for some time, but the timing has continued to be pushed further back as the economy was stuck in the doldrums. The economic doldrums are, however, ameliorating, and the U.S. economy seems to be gradually gaining momentum. This means that the long-awaited Fed taper, the turning off of the spigot of “free money” to the economy, is likely to come to an end soon.

Federal Reserve Fed taper

Deutsche Bank Markets Research issued a report Wednesday titled “Impact of Fed Taper/End of QE on Banks; Downgrading Citigroup Inc (NYSE:C) and Morgan Stanley (NYSE:MS)” detailing their opinions on the timing and effect of the looming Fed taper. The report was authored by Matt O’Connor and colleagues.

Fed taper: Taking away the training wheels

The DB Markets Research report begins by highlighting the magnitude of the Fed’s bond-buying program. “Since QE3 began a little over a year ago, the Fed has added ~$1 trillion to its balance sheet and $3 trillion since late 2008. In addition, flows into fixed income assets have been strong (at least until about 6 months ago), totaling $900b since late 2008. Combined, Fed purchases and investor flows have averaged $800b per year since late 2008.”

They also point out that removing this big liquidity boost to the financial system is a risk, even if gradually and carefully staged, and that there are real risks involved in the process.

Fed Taper

Taper as a double-edged sword

O’Connor and the Deutsche Bank Markets Research team advance the argument that the impending Fed taper is in reality a double-edged sword. That is, while shutting off the spigot will certainly have an impact on many sectors of the economy, it also means a return to more stable macroeconomic conditions where banks can make profits.

Their thesis is: “If economic growth accelerates to the 3%consensus level in 2014 (from ~2% in 2013), additional P/E multiple expansion for banks (and the overall market) seems likely given rates remain low on an absolute basis, inflation is low and P/E multiples aren’t stretched (although are in line with historical levels). On the other hand, we worry about the potential combination of widening of credit spreads and rising interest rates; and the impact these may have on cost of funding, certain industries that are rate sensitive (like housing, FICC trading) and certain emerging markets”

Downgrading Citibank and Morgan Stanley

The report also announces that DB Markets Research is downgrading Citigroup Inc (NYSE:C) and Morgan Stanley (NYSE:MS) from Buy to Hold, largely related to concerns regarding current high valuations and the macroeconomic environment during and post-taper.